In the last months of World War I, the British government convened a commission on the future of monetary policy. Weighing the opinions of twenty-three experts, it found unanimous support for a return to the prewar gold standard.1 Gold was seen as a pillar of a free society, a bulwark against government abuse; there was no other tried and tested basis on which to rebuild international finance. And yet despite this expert unanimity, the decision to return to the gold standard proved disastrous, both in Britain and abroad: until it was abandoned, it deprived the monetary authorities of the tools to fight the Depression. At the end of his life, Montagu Norman, the revered governor of the Bank of England and chief personifier of the gold pledge, offered a poignant confession. “With all the thought and work and good intentions, which we provided, we achieved absolutely nothing . . . we collected money from a lot of poor devils and gave it over to the four winds.”2
Three quarters of a century later, an idea that could be thought of as the opposite of the gold standard was similarly tarnished. It consisted of a broad faith in financial innovation: the conviction that a few spectacular mishaps notwithstanding, the paraphernalia of tradable risks and income streams was a force for progress. Whereas the gold standard had promised sober discipline—it would prevent governments and private lenders from creating money and credit promiscuously—modern finance promised exhilarating license. By isolating risks and dispersing them, it would allow companies and families to borrow more, and safely: the primitive straitjacket of gold would be displaced by the permissive elegance of risk-measurement models. But just as the progold consensus of 1918 led to disaster, so the modern tolerance for financial innovation turned out to be too trusting. Alan Greenspan, the revered chairman of the Fed and chief personifier of the new instruments, would see his reputation suffer—although he would never quite match Norman in declaring his life’s work to have been futile.
When ideas succeed in one period and then fail in the next one, it is because the conditions required for their success have been eroded. The gold standard underpinned a period of advance in the late nineteenth century; then, after World War I brought about a lopsided distribution of gold among the main economies, it became a catastrophe waiting to happen. Similarly, the faith in modern finance served the advanced economies well for some four decades, spanning the first breaches of Regulation Q in the early 1960s to the profusion of securitization and derivatives in the early 2000s. But then, by an alchemy that almost no contemporary appreciated, finance tipped into a dark zone. Experiments that had once been merely bold became outrightly brazen. Risks that had never been large enough to threaten the entire system took on an unimaginable scale.
The tipping point came somewhere around 2004, when the fans of the Texas Rangers baseball team were introduced to a new name—not Alfonso Soriano or Joaquín Arias, the players traded by the New York Yankees earlier that year; and not Gerald Laird, the team’s new starting catcher. Rather, the new name belonged to the ballpark—Ameriquest Field in Arlington—after the Rangers signed a $75 million sponsorship deal with the nation’s largest subprime mortgage lender.3 Around the same time, Ameriquest’s chief rival, an upstart named Countrywide, splurged on underwriting golf tournaments; and the mortgage division of the big West Coast lender Wells Fargo almost courted an image of imprudence by sponsoring extreme sailing.4 Angelo Mozilo, the boss of Countrywide, would stand up in front of investors in this period and rattle off a startling list of mortgages. “We have ARMs, one-year ARMs, three-year, five-year, seven- and 10-year,” he would say dizzily, referring to the adjustable-rate mortgages that Countrywide peddled. “We have interest-only loans, pay-option loans, zero-down programs, low-, no-doc programs, fast-and-easy programs, and subprime loans.”5 He sounded for all the world like a carnival barker.
The new mortgage mania was a grotesque caricature of the healthy innovation that had come before. In the past, borrowers with slightly dubious credit had turned to subprime lenders who overlooked their weaknesses in return for higher interest payments; this was financial flexibility of the reasonable sort. Now borrowers with truly awful credit could borrow without even documenting their earnings, which was not reasonable at all.6 In the past, similarly, borrowers with temporarily low incomes—for example, a couple in which one partner was taking time out to complete college—could get a mortgage with a low initial rate that would go up after a year or two. Now adjustable-rate mortgages were abused to give borrowers an early repayment holiday in exchange for punitive rates later, with no obvious reason to expect the borrowers’ incomes to rise commensurately. The old practice of requiring home buyers to make a down payment out of their own savings was thrown to the four winds also, so that now a decline in house prices would leave them with no equity in their homes. “Ten years ago, if I offered to buy your house with a 100 percent loan, you would have called it ‘creative financing’ and thought I was crooked,” observed a real estate agent in Anaheim. “Today, everybody wants a 100 percent loan.”7
By the middle of 2004, the mortgage industry was on track to pump out almost double the volume of subprime loans it had made one year earlier.8 Even more alarmingly, fully one third of subprime mortgages were being extended without meaningful assessments of borrowers’ financial status, and borrowers were seduced with all manner of payment holidays that increased their indebtedness later.9 Far from registering anxiety about this mania, the mortgage firms presented it as progress. Thanks to computerized mortgage underwriting, default risks could be calibrated without formal documentation of income, or so the lenders asserted; loans with minimal credit checks were gloriously liberating, not menacingly dangerous. But the reality was less comforting, for this blizzard of new-fangled mortgages was intimately connected with another financial transformation. Increasingly, the firm that originated a mortgage was not the firm that held it for the long term; instead, banks and other lenders were selling the mortgages to firms that bundled them together and sliced them into securities that were then resold to distant investors. Not only did this allow lenders like Ameriquest and Countrywide to maximize the number of mortgages they could churn out on relatively little capital, but it also minimized the amount of risk they took on in the process. If borrowers defaulted, it was not Ameriquest’s or Countrywide’s problem. No wonder Angelo Mozilo stood ready to lend to just about anyone.
This packaging and securitizing of mortgages was another example of a practice that had worked well for a long period and then tipped into a crazy zone. Like the earlier, more reasonable incarnations of subprime lending, the early mortgage-backed securities had mostly been healthy for the financial system—the claim that they allowed default risks to be dispersed widely was in fact true. But then this trend reached its extreme limits. Rather than merely turning mortgages into mortgage securities, financiers began to issue securities backed by other securities, creating strange instruments known as “collateralized debt obligations, squared.” A complex tiering was superimposed on these confections, with “senior” tranches of CDOs and CDOs-squared having the first claim on repayments and “junior” tranches accepting greater default risks in exchange for higher interest payments. The more byzantine the construction, the harder it became for investors to understand what they were purchasing. “We had meetings where I would say, ‘Are you sure you’re comfortable with that?’” one mortgage executive recalled later. “And they would bring in the quants!”10
Taken by themselves, none of these experiments would have been too dangerous. But the cocktail of “no-doc” lending, zero-down payments, and opaquely complex mortgage derivatives mixed perilously with other factors. The government was pushing Fannie and Freddie to lend more to low-income borrowers, and the GSEs responded by loading up on subprime mortgages, stoking the mania with a big increase in demand. Meanwhile, the loose monetary policy Greenspan had adopted out of fear of a Japan-style slump was bearing down on interest rates, and investors grew desperate for the income promised by mortgages, no matter how opaque the tiering or how scant the documentation. So strong was the appetite that three out of every four new conventional, “prime” home loans were securitized in 2004, up from one out of two just four years earlier. The securitization rate for higher-yielding subprime loans took off like a rocket, soaring from 40 percent to 73 percent over the same four years. It would peak at nearly 93 percent on the eve of the financial crisis.
Because of investors’ insatiable demand for mortgage securities, mortgage originators had no incentive to lend carefully; all that mattered was to lend copiously. Loan officers at Ameriquest were made to put in “power hours,” nonstop cold-calling sessions to potential borrowers; those who racked up big numbers won trips to Hawaii and the Super Bowl, while those who failed to win new customers were thrown overboard. “I was told I was going to be fired at least 200 times,” an Ameriquest employee recalled later; the boss would constantly be asking him, “Why can’t you do more?” A movie called Boiler Room, which captured the culture of fast-talking stock swindlers, became required watching at some Ameriquest branches. The film imbued employees with “the energy, the impact, the driving, the hustling”—the full menu of qualities, in other words, that would spur a frightened sales team to inflate the mother of all bubbles.11
• • •
By this stage in his life, none of these developments should have surprised Greenspan. He had watched financiers overreach repeatedly since the collapse of Penn Central in 1970; he had seen Charles S. Sanford, the hapless boss of Bankers Trust, fail to understand the complex swaps that his sorcerers supplied to Procter & Gamble and Gibson Greeting Cards. If the Bankers Trust traders had talked about the “ROF factor,” or rip-off factor, back in 1994, it ought to have been obvious that the byzantine CDOs-squared were intended to bamboozle clients—“to lure people into that calm and then just totally fuck ’em,” as a Bankers Trust trader had put it. But Greenspan had long since arrived at a position about finance that mirrored his position on bubbles. He understood that financiers could be foolish, and sometimes even fraudulent, but he doubted that the Fed had the manpower or the political mandate to restrain them. “Where we are most vulnerable is with regard to the adequacy of our examinations,” Greenspan had observed after the Fed’s failure to restrain the banks that had lent heedlessly to Long-Term Capital Management. “If we had to meet the standards that people think exist, we would have five times as many examiners.”
Having arrived at this conclusion, Greenspan had embraced a pair of assumptions that he knew to be precarious. First, however reckless financiers might sometimes be, their risk managers would generally restrain them, perhaps prodded by regulators who might help at the margin. Second, when risk management did fail, the Fed would clean up afterward—disciplining miscreants like Bankers Trust, bailing out banks like Continental Illinois, cutting interest rates aggressively in the face of shocks such as the failure of Long-Term Capital Management. Like the pre-1914 gold standard, these assumptions had held up over a long period.12 There had been crises, certainly. But cleaning up afterward had more or less succeeded.
Because of this mind-set, Greenspan refused to act preemptively to curb the feverish mortgage market in 2004. “American consumers might benefit if lenders provided greater mortgage product alternatives,” he told an audience in February, apparently unperturbed by the eye-popping buffet of mortgages that was already on offer.13 “Risk modeling has improved in accuracy and will continue to do so,” he announced cheerfully in April, as though the quants at Ameriquest and Countrywide could be relied upon to manage risks safely.14 With the unfair benefit of hindsight, this sunny complacency was a clear error, because a regulatory clampdown on wild mortgages and securitization could in principle have addressed the 2008 crisis at the source, mitigating the damage far more directly than tighter monetary policy could have. But if we are to draw the right lessons from this episode, it is important to be clear that Greenspan did not commit this error absentmindedly, and he was not alone. Just as the gold standard commanded near-universal confidence in Britain in 1918, so Greenspan’s complacency on housing was shared by nearly everyone.
This point bears emphasizing because, in the years after the crisis, a contrary narrative emerged. According to this imagined history, Greenspan was warned about the coming real estate meltdown and took it upon himself to do nothing. For instance, the Greenlining Institute, an organization seeking to protect minorities from predatory lending, sent Greenspan a pile of mortgage documents showing how opaque the new loans could be. “Even if you had a doctorate in math, you wouldn’t understand these instruments and their implications,” Greenspan reportedly acknowledged during a follow-up meeting.15 In another example, a delegate from the National Community Reinvestment Coalition pointed Fed officials toward examples of predatory lending. “Their response was that the market would correct any problems,” the delegate recalled after the crisis; “Greenspan in particular believed that the market would not produce, and investment banks would not buy, loans that did not make sense.”16 But quite apart from the question of whether a handful of suggestive conversations constitutes a real warning, the key problem in the anti-Greenspan narrative lies in what the consumer advocates were saying. They were not predicting a threat to the financial system; rather, they were advancing a narrower claim that the Fed should protect vulnerable groups from imprudent borrowing.17 Most prominent mortgage critics, in other words, failed to connect the dots between sharp sales practices and the risk of a financial crisis.18 And this was only natural. Subprime lending and mortgage securitization had been around for years without triggering a catastrophe.
This failure to connect the dots between abusive lending and systemic risk is illustrated by the story of Edward Gramlich. Tall, affable, and possessed of a kindly humor, Gramlich was the Fed governor in charge of the consumer and community affairs committee, the perfect platform from which to sound the warning about predatory home lending. As early as the summer of 2000, Gramlich duly held hearings around the country, soliciting complaints from residents and activists about abusive mortgages.19 Sure enough, he found horror stories aplenty. Borrowers had been bamboozled with surprise fees, altered documents, unnecessary refinancings, and disclosure forms more convoluted than a Pynchon novel.
“I wish you guys could do something,” fumed one home owner from Brockton, Massachusetts. “We pray to a higher God up above, a spiritual God. These people that are doing these loans, they’re praying to a higher money called the color green.”20
Gramlich was sympathetic. If there was clear evidence of abusive lending, he wanted the details.
At one of the hearings, the chief legal counsel of Countrywide explained why his firm regularly lent to people who could not prove their earnings.
“If you can’t document the income, how do you know the income, and how do you know they can pay the loan back?” Gramlich demanded.
“I would say that there are certain reality checks, let’s just say,” the Countrywide man waffled. If a waiter claimed to earn $300,000, the application would be denied, he went on. “So it is a more difficult—it’s a more difficult task.”
The answer sounded shifty. But after sitting through hours of hearings in four cities, Gramlich was still uncertain of how much abuse was really going on. He had to weigh complaints of predatory lending against complaints of the opposite variety: activists frequently lamented that banks refused to lend to low-income borrowers, even at a premium interest rate. A blanket clampdown on subprime mortgages would deprive some legitimate borrowers of a shot at home ownership; if the Fed acted heavy-handedly, the poor might suffer. And even if Countrywide’s legal counsel was annoyingly evasive, presumably the risk managers at his company had quantified their exposure? Not knowing what to make of all this, Gramlich asked his staff to design a “pilot program” of spot checks on six to eight mortgage lenders in the hope of gathering more evidence.
What happened next would later be the subject of controversy. At some point in the late summer of 2000, Gramlich suggested the pilot program privately to Greenspan, and Greenspan expressed doubts; in the years after the crisis, this was held up as the moment when the laissez-faire chairman condemned the nation to the subprime meltdown. “He was opposed to it, so I didn’t really pursue it,” Gramlich told the Wall Street Journal in 2007; “Did Greenspan Add to Subprime Woes?” ran the title of the Journal’s article.21 Up to a point, the implied criticism was justified: if Gramlich’s pilot program had been pursued, the Fed might have curbed lending abuses, slowing the gusher of uncollectable loans that fueled the financial crisis. Perhaps, to push the point a little further, the pilot program might have led the Fed to a broader understanding of the mortgage mania, which in turn might have alerted it to the perils in extreme securitization: on this theory, predatory lending was the smoke that might have led Greenspan to the fire.22 But the awkward truth is that Gramlich left Greenspan plenty of room to doubt his pilot program. The spot checks would be “limited in scope,” as a Fed staff memo noted, but they would also be “resource intensive”—hardly a seductive combination. It was by no means certain that the checks would turn up evidence of abuses sufficient to warrant a clampdown; yet they were likely to “raise expectations,” as the staff memo put it, exposing the Fed to “more intense public and political criticism if it decides not to go forward.”23 In sum, Gramlich was proposing an expensive fishing expedition that might cause political trouble and have limited effect. It is understandable—if not, in hindsight, commendable—that Greenspan balked.
Gramlich himself seems to have believed that Greenspan was being reasonable. Once the chairman had registered his resistance, Gramlich dropped his proposed pilot program quietly—hardly a sign that he had overwhelming faith in it. “When Ned was on to something, he was tenacious,” a fellow governor recalled later, citing Gramlich’s insistent advocacy on other issues. In this instance, however, Gramlich chose not to press his case.24
That was neither man’s last word on predatory lending, however. Over the next weeks, Gramlich’s staff considered other ways of reining in the kinds of abuses reported at that summer’s hearings. This time, rather than proposing a pilot program of inspections, they crafted a series of consumer-protection rules for the most abusive lending practices.
Writing these rules involved delicate judgments. There was a fine line between measures that prevented consumer rip-offs and measures that smothered consumer choice. If the Fed banned all no-doc loans on the ground that they were too risky, for example, shopkeepers and other small-business owners might have trouble buying a home: because they were self-employed, they lacked standard wage documents.25 If the Fed banned adjustable-rate mortgages, it might likewise penalize workers who could genuinely expect to earn more in the future. To get around this sort of problem, the Fed staff decided against banning a specific set of mortgage practices. Instead, it required lenders to make a good-faith judgment about a loan’s impact on the borrower.
In December 2001, the staff presented the proposed rules to the Fed’s board. The directives aimed among other things to stop lenders packing mortgages full of exorbitant insurance fees. They also prohibited refinancings that were not “in the borrower’s interest.”
Greenspan was uncomfortable with that last provision. “In the borrower’s interest” sounded vague. He preferred bright lines to mushy exhortations.
“Who makes that calculation?” Greenspan demanded.
The staff replied that the creditor would make it.
“How does he make that?” Greenspan pressed.
It’s the “totality of the circumstances,” the staffer answered.
“In other words, it’s their judgment, but they are responsible to defend it if challenged?”
“That’s correct.”26
Evidently, if the rules were approved, lenders would have to retain lawyers to advise them on the meaning of “borrower’s interest,” not to mention “totality of circumstances.” The cost of compliance would push mortgage costs up, perhaps hurting the very borrowers whom the Fed sought to protect. The advantages of regulation had to be weighed against the costs. It was hard to be sure what the right balance was.
To make matters worse, approval of the rules did not guarantee their enforcement. The Fed had the authority to inspect bank-holding companies and, at least in theory, their subsidiaries, but myriad lenders fell outside its net; the Fed would have to depend on an alphabet soup of other regulatory agencies to help enforce its mortgage policies. Some of these agencies were underfunded and short on expert staff; the Federal Trade Commission, which had authority over nonbank mortgage originators, did not conduct any on-site inspections.27 Uneven supervision would surely drive unscrupulous lenders into the arms of the agencies least equipped to restrain them.
Presently, Edward Gramlich spoke up. Contrary to the later myth that grew up around him, he downplayed the gains to be had from writing stricter mortgage rules. Instead, he pinned his hopes elsewhere, telling the board that “the very best defense is education and financial literacy.”28
Despite these reasonable misgivings about the proposed rules, the board voted unanimously to approve them. Again contrary to later myth, the Greenspan Fed did at least attempt to curtail mortgage abuses. Years later, with the benefit of hindsight, it became obvious that the Fed should have gone further: in 2008, the Fed issued tougher rules, requiring among other things that borrowers’ tax and insurance payments be factored into the calculation of the size of mortgage they could afford. But in the early 2000s, almost nobody wanted to go that far—not the regulators on the Fed staff, not Edward Gramlich, and certainly not Congress. Moreover, the results of Greenspan’s regulatory effort seemed partially to validate the misgivings. Subprime lenders skirted the new regulations by tweaking their methods; for example, when they were forbidden to extract extra fees by refinancing a home more than once in a year, they simply waited 366 days before flipping a customer from one mortgage to the next one. Within a few years, the Fed’s 2001 rule making had been almost entirely evaded: originally, the Fed’s staff had estimated that the rules would affect 38 percent of subprime loans; by the end of 2005, they affected about 1 percent.29 Perhaps discouraged by this experience, nobody at the Fed pushed for additional mortgage restrictions until the end of Greenspan’s tenure.
In August 2007, a fortnight before dying of cancer, Gramlich wrote a farewell letter to Greenspan.
“I thought you were a magnificent central banker and a great leader,” Gramlich wrote graciously, before adding, “I suppose we all go out with one item of unfinished business.”
Referring to the recent Wall Street Journal article, which recounted how Greenspan had blocked his pilot program, Gramlich went on, “For me it is that I truly wish the press would stop kicking you around on this subprime supervision issue. What happened was a small incident, and as I think you know, if I had felt that strongly at the time, I would have made a bigger stink.
“But that aside, I will always treasure our days together.”30
• • •
The Fed’s attempted clampdown on mortgage abuses in 2001 underlined Greenspan’s pragmatism. Despite his reputation as a laissez-faire ideologue, he was prepared to countenance regulation when the case seemed reasonable, even though he generally believed that private risk managers would perform better than government overseers. The same pragmatism was evident following the Enron scandal, when Greenspan advocated tougher regulation of corporate accounting and spoke out against Fannie Mae and Freddie Mac, the two GSEs that owned or guaranteed nearly half of all mortgages. Moreover, in 2004, Greenspan went back on the offensive against the mortgage giants.
Greenspan’s position on the GSEs had not always been a profile in courage. Ever since his diagnosis of the 1970s housing boom, he had understood how they could warp finance; but whereas he had fought doggedly to protect the Fed’s monetary independence and its supervisory turf, he had deliberately sidestepped the challenge of reining in Fannie and Freddie. In the early 1990s, for example, a staff economist in the Senate conceived a plan to curb the GSEs by empowering the Fed to regulate them; as soon as Greenspan got wind of this idea, he placed a call to the startled economist and bluntly declared that the Fed would not accept this mission.31 Later in the 1990s, Greenspan learned that Richard Baker, the Louisiana congressman who chaired the House Subcommittee on Capital Markets, was plotting legislation to contain the GSEs; Greenspan invited Baker over to breakfast, congratulated him on doing the right thing, but stressed that he could support his efforts only privately.32 In the last year of the Clinton administration, both Baker and the Treasury revived the notion that the Fed could oversee Fannie and Freddie. Again, Greenspan declined. He was happy to advise behind the scenes. He was not going to risk a head-on fight with the GSEs’ lobbyists.
Greenspan’s veiled attack on the mortgage giants in 2002 had signaled a new willingness to stick his neck out. Egged on by politicians from both parties who loved to preach the merits of home ownership while pocketing campaign contributions from Fannie and Freddie, the housing giants had grown to such a size that they could not be ignored any longer. Whereas individual mortgage originators such as Ameriquest and Countrywide appeared too small to pose a risk to the financial system as a whole, the GSEs were clearly large enough to do so. Worse, the logic of the GSEs’ subsidies created a perverse incentive to grow even bigger. The more they expanded, the nastier the mayhem if they went bust—and therefore the stronger the presumption of a government backstop, which in turn enabled them to borrow even more cheaply. The subsidy from the implicit backstop empowered them to grab market share, which in turn empowered them to grab more subsidies.
In February 2004, Greenspan testified before the Senate. Pointing to the fact that the GSEs’ expanding portfolios were backed by extraordinarily thin buffers of capital, he gave warning of “a systemic risk sometime in the future.”33 To avert such a crisis, Greenspan continued, the government would have to step in. The GSEs needed a serious regulator, and that regulator should cap the size of their portfolios.
Senator Richard Shelby, the chairman of the banking committee, followed Greenspan’s observation to its natural conclusion. If the GSEs were too big to fail, weren’t megabanks also a problem?
“What about large banking institutions like Citigroup or Bank of America?” Shelby asked. “Do they receive a similar funding advantage?”
“I think they receive some,” Greenspan answered, frankly acknowledging the risk posed by behemoths that had grown up on his watch.
“Have you ever quantified that, has anybody at the Federal Reserve?” Shelby wondered. He was inviting Greenspan to explain why the GSEs should be singled out for special attention. Was the Fed chairman merely acting on his libertarian bias—on a prejudice that government-chartered lenders were intrinsically more troubling than private ones?
Greenspan insisted otherwise. Yes, he told the senator, the megabanks could borrow slightly more cheaply because they might be too big to fail, but these subsidies had indeed been quantified—and they were far smaller than for the mortgage giants. Besides, banks maintained thicker capital cushions and were subjected to more supervision. Greenspan was targeting Fannie and Freddie on the basis of facts, not ideology.
“But there is a perception by some people that some of the largest banks are too big to fail,” Shelby pressed again.
Greenspan stood his ground. “If you look at the prices of their securities in the marketplace,” he said, referring to the banks, “it’s fairly evident that there is very considerable question as to whether in the event of failure that they will in fact be bailed out. That is far less the case on the part of the securities of Fannie and Freddie.”
Greenspan was right. Market data, not Friedrich Hayek or Ayn Rand, informed his regulatory focus. And the market’s response to his testimony underlined his point. By the end of the day, the GSEs’ stock prices had fallen by around 3 percent. Evidently, their valuations were based on the presumption that Washington would underwrite their expansion. Some tough words from the Fed chief were enough to raise doubts about that.
Even before Greenspan finished speaking, however, the mortgage giants counterattacked. Showing remarkably little deference to Greenspan’s stature, Fannie Mae rushed out a statement, brazenly accusing him of misunderstanding the mortgage business.
“The testimony does not appreciate the role of our mortgage portfolio,” Fannie’s statement complained. Limits “on Fannie Mae’s mortgage portfolio business would force the housing finance system to rely more on large banks, which are not required—or structured—to . . . lower mortgage costs.”
There was barely any truth in Fannie’s complaint: the GSE portfolios did almost nothing to make mortgages cheaper for home buyers. Indeed, Fed researchers had recently measured the reduction and found it to be vanishingly small. The GSEs’ borrowing subsidies enriched their shareholders and executives, not their borrowers.34
Fannie’s denunciation of Greenspan was soon followed by Freddie’s. It was regrettable that the chairman had diverted attention from important matters “to a more theoretical discussion,” Freddie said gravely; restricting the GSEs’ portfolio size would “increase the cost of mortgages for America’s homebuyers.”35 There was that same lie, again. The giants were clearly not going to give up on it.
Five weeks later, the Senate returned to the question of restrictions on GSEs. The day before the hearing, an ad appeared on television.
The screen showed a worried-looking Hispanic couple.
Man: “Uh-oh.”
Woman: “What?”
Man: “It looks like Congress is talking about new regulations for Fannie Mae.”
Woman: “Will that keep us from getting that lower mortgage rate?”
Man: “Some economists say rates may go up.”
Woman: “But that could mean we won’t be able to afford the new house.”
Man: “I know.”
This time the big lie demonstrated an even bigger truth. Government subsidies to the mortgage giants might not reduce the cost of housing loans; but they did generate a political war chest, enabling Fannie to run TV commercials. Subsidies paid for ads aimed at perpetuating subsidies.
“Here is an organization that was created by the Congress . . . spending money questioning the Congress’s right to take a serious look at oversight . . .” sputtered Senator Chuck Hagel. “I find it astounding. Astounding!”36
As shameless as Fannie and Freddie might be, there was no doubting their effectiveness. The TV commercial sent out an unmistakable message: members of Congress who voted to cap the GSEs’ portfolio size would have to run for reelection against a barrage of mendacious ads in their home districts. Not at all surprisingly, the majority of lawmakers took fright; and by the late spring of 2004, the mortgage giants had emerged victorious. Never mind what the White House and the Fed chairman might urge. There would be no new regulation.
• • •
Greenspan’s failure on the GSEs compounded his inaction on the mounting excesses in the private mortgage market. He had attempted to curb Fannie and Freddie, testifying insistently to Senator Shelby on why they posed unusual risks, but his efforts had proved inadequate. He had averted his eyes from private mortgage originators like Countrywide, although, in his defense, neither consumer advocates nor his own staff flagged them as a systemic menace. The fact that Greenspan’s actions were ineffectual and yet somewhat understandable stands as a warning to his successors. After the 2008 meltdown, central bankers resolved to use regulatory policy, not monetary policy, to head off the next crisis. But regulatory tools are hard to wield. They involve confronting brutal lobbies: witness Fannie’s TV ad. They involve interpreting vague reports of market abuses: witness Edward Gramlich’s diffident advocacy of a pilot supervisory program. And they involve writing rules that are flexible enough not to be oppressive, yet tough enough to change behavior. This is a tricky balance to strike: witness the failure of the Fed’s attempt in 2001 to clamp down on subprime abuses. Moreover, these challenges in implementing regulation extended beyond mortgage origination to other bits of the food chain—notably to the Wall Street banks that packaged, securitized, or invested in home loans.
In November 2003, Greenspan acquired a new lieutenant at the New York Fed: a hard-charging forty-two-year-old named Timothy Geithner. Fit, foulmouthed, boyishly cherubic in his looks, Geithner was a protégé of Bob Rubin, whose ability to catapult favorites into lofty jobs was legendary. Now, having spent the 1990s at the Treasury handling emerging-market crises, Geithner brought his experience with collapse to the task of regulating Wall Street. Knowing that regulators could not anticipate where the next shock would come from, Geithner aimed to boost the financial system’s overall resilience. He notched up some considerable victories—in particular, the plumbing of the derivatives market, which had consisted of a frightening mess of unconfirmed paper trades, was modernized, silencing one dog that would otherwise have barked during the 2008 crisis. But Geithner also wanted to increase Wall Street’s capital buffers so that the big houses could weather unanticipated shocks. On this goal, he soon ran up against the limits of regulation.
The idea of requiring banks to hold more capital had enthralled regulators, including Greenspan, since the 1980s. Paul Volcker had conspired successfully with the Bank of England to force the Basel Accord on banks, laying down the minimum amount of capital relative to loan portfolios. But as Greenspan had noted after the Continental Illinois disaster, there was no certain way to determine how much capital was right—much depended on the types of risks that banks shouldered. Now, as Geithner tried to build more robust buffers into the financial system, this lack of objective criteria became a problem. He could form his own judgment about the right amount of capital, and attempt to force it on the banks that came under his jurisdiction. But then borrowing and lending would migrate to institutions that lay outside the Fed’s purview: to investment houses such as Bear Stearns; to Fannie and Freddie; to myriad “shadow banks”—money-market funds, auto-loan providers, and so on. Because it was hard to demonstrate conclusively how much capital these players required, nobody was going to stop them from carrying on as they were: the difficulty in specifying bright-line rules combined with the fragmentation of the regulatory system to frustrate Geithner’s quest for resiliency. “Our capital buffers were too thin, but they were already thick enough to drive trillions of dollars of assets—more than were in the entire commercial banking system—outside our direct supervision,” Geithner recalled ruefully.37
Determined not to give up, Geithner attempted to gain traction over investment banks and shadow banks via what he called the indirect channel. He prodded the banks he did supervise to demand larger buffers at the less regulated players they dealt with. If the New York Fed lacked the direct authority to get shadow banks to build up more resiliency, perhaps it could get at them by generating peer pressure.
To ensure he had support for this approach, Geithner checked in with the Fed chairman.
“That’s what you’re supposed to do,” Greenspan assured him.38
And yet, despite Greenspan’s blessing, Geithner’s push for extra capital ended in failure. It was one thing to demand better plumbing in the derivatives market—the banks recognized that this was in their own interest. It was quite another to demand thicker capital buffers in a financial environment in which traders lusted for more risk. And so, in the end, the Fed’s efforts did little to promote resiliency. “The Wild West with better plumbing was still the Wild West,” Geithner conceded.39
• • •
If the Fed’s regulatory defeats stand as a warning to Greenspan’s successors, its monetary debates challenge the postcrisis consensus on interest rates and asset bubbles. After 2008, central bankers and economists generally concluded that monetary policy had been almost irrelevant to the mortgage bubble. In a speech in January 2010, for example, Ben Bernanke, who by then had succeeded Greenspan as Fed chairman, declared that “only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy”; and in a paper published by the Brookings Institution the following spring, Greenspan presented his own version of this argument.40 And yet at the time the bubble was inflating, this claim of monetary impotence would have been regarded as strange. Greenspan and his FOMC colleagues took it for granted in 2004 that monetary policy was affecting asset prices, including house prices.
This recognition was evident during the FOMC discussion at the end of January 2004, for example. By now the federal funds rate had been down at 1 percent for seven months, and the Fed had pledged to stay loose for a “considerable period” after four successive meetings. Over the same seven-month period, the S&P 500 index had gained almost a fifth. Investors had bid down the interest rates on mortgage securities until they were barely higher than safe government bonds. As a result, mortgage lending was booming. House prices had leaped by a tenth over the period.
“These markets have the potential over time to feed into the types of speculative excesses that were so damaging . . . in the late ’90s,” Cathy Minehan of the Boston Fed worried to her FOMC colleagues.
“Financial conditions are now very accommodative,” agreed Timothy Geithner. “These factors make the fundamentals look better than they probably are. They make us more vulnerable to the buildup of distortions in financial markets that can only be unwound with some drama.”
“Bankers are willing to take on more risk than I have heard them admit to in recent years,” added Governor Mark Olson, who was himself a former banker.
Vice Chairman Roger Ferguson pushed the argument further, linking the financial exuberance with the Fed’s forward guidance about future interest rates. “Perhaps we are anchoring the yield curve more than we’d like,” he suggested. “The fixed-income markets in particular are not in fact doing the appropriate job of pricing risks.” He was suggesting that the Fed’s forward guidance had made life too predictable, lulling speculators into complacency. “We need in some sense to remove the anchor that we have placed on those markets,” he concluded.
Greenspan also sounded worried. “It sounds as though we’re back in the late ’90s or perhaps early 2000,” he said, recalling the extremes of the tech bubble. “When we get down to the rate levels at which everybody is reaching for yield, at some point the process stops and untoward things happen.”
After the crisis, those who downplayed the relevance of monetary policy would argue that the low federal funds rate affected only short-term borrowing rates; therefore, because mortgages were mostly long-term, the Fed could not be held responsible for the housing bubble. This was in itself a dubious claim: in 2003 and 2004, about one third of home-loan applications were for mortgages with teaser rates linked to the fed funds rate.41 But as Greenspan’s “reaching for yield” comment recognized, the larger point was that a low and predictably stable federal funds rate set off a general scramble on Wall Street. Banks and investment houses felt safe in borrowing cheap overnight money because the Fed had assured them that the cost of such borrowing would not rise suddenly. They used this short-term borrowing to buy higher-yielding longer-term debt—including, not least, securitized mortgages. In this way, credit funds known as “SIVs” and “conduits” bridged the supposed divide between the federal funds rate and longer-term market interest rates. The general scramble for yield explained why, as Roger Ferguson observed, risky bonds were not being priced appropriately.42
“The potential snapback effects are large,” Greenspan went on. “We are always better off if equity premiums are moderate to slightly high or yields are moderate to slightly high because the vulnerability to substantial changes in market psychology is then obviously less.” Exuberant markets posed a risk, in other words. “In my view we are vulnerable at this stage to fairly dramatic changes in psychology,” Greenspan said ominously.
Summing up this threat of a “snapback,” Greenspan was certain where it came from. “We are undoubtedly pumping very considerable liquidity into the financial system,” he declared. If a bubble was growing, in other words, monetary policy was at least partially responsible.
• • •
The FOMC discussion of January 2004 confirms the weakness in the postcrisis consensus about excess leverage and asset bubbles. It is true that a regulatory clampdown on wild mortgages could have mitigated the crisis more directly than higher interest rates could have, but as we have seen, the regulatory response failed and will likely fail in future. On the other hand, Greenspan’s discussion of “reaching for yield” shows that the Fed did at least contemplate ideas that made a monetary response conceivable. The FOMC identified the risk of a market reversal, and it understood that its own policy of low rates and forward guidance was contributing to the frothy markets that would make a reversal painful. Moreover, if it had chosen to tighten monetary policy, there would have been none of the rule-writing dilemmas or agency turf battles that made regulation difficult: raising interest rates would have been straightforward. And yet by the end of the January meeting, the Fed had decided not to counter the potential speculative snapback by increasing the fed funds rate.
The case against using monetary policy to restrain home prices was advanced by Don Kohn, the FOMC member who was closest to Greenspan. Agreeing with others around the table, Kohn accepted that low interest rates were pumping up markets. In his view, this was hardly a surprise: the Fed’s monetary lever always worked by revving up interest-rate-sensitive sectors of the economy such as housing.43 But Kohn had doubts about the next step in the analysis. Just because house prices were revved up, it did not necessarily follow that there was a bubble.
“It’s about second-guessing asset-price levels,” Kohn cautioned. “It’s something we didn’t do in the stock market run-up in the ’90s, and I was pretty comfortable with how we handled that. So I’d be a little cautious about using monetary policy to try to damp asset-price movements.”
“I certainly agree with that,” Greenspan responded.
Greenspan and his chief lieutenant were not willing to act against potential bubbles unless they had conclusive proof of their existence, which was another way of saying that they would never act against them.44 Having weathered the implosion of previous bubbles, in 1987, 1994, and 2000, they had reason to believe that history was on their side. If house prices did turn out to constitute a bubble, they could always clean up afterward. The danger of a snapback had to be weighed against more certain and immediate goals: to allow as much growth and employment as possible, consistent with a stable consumer-price index.45
• • •
For the next few months, the Fed continued to guide investors about its future policy, oblivious to Roger Ferguson’s warning that this might “anchor” the yield curve and lull investors into complacency. In March 2004 the FOMC repeated its promise to be patient about raising interest rates; in May it declared it would tighten “at a pace that is likely to be measured.” It was only in June, after fully twelve months with a 1 percent federal funds rate, that the FOMC ventured a quarter-point hike. By this point, house prices had risen by 20 percent in a year.46 It was the same amount that they had gained during the entire decade of the 1990s.
The June 2004 rate hike marked the start of a long tightening cycle. But it was nothing like the tightening cycle of ten years earlier. In 1994, the Fed had kept the market guessing, sometimes hiking by 25 basis points, sometimes by 50 basis points, and once even by 75 basis points.47 But in 2004, having promised to tighten at a “measured” pace, the Fed made good on its undertaking. After each FOMC meeting, it tightened by 25 basis points—not more, not less. Far from surprising leveraged speculators and triggering a new version of “Hurricane Greenspan,” the Fed proceeded with as little disruption as possible.
The calm in the markets was so complete as to be eerie. Assured of the Fed’s “measured” intentions, banks and investment houses remained content to borrow copiously at short-term rates, which were still low by historic standards. They used this cheap funding to bid down long-term rates, with the result that long rates did not follow the fed funds rate upward. In fact, Wall Street was so elated that the tightening would be “measured” that it borrowed short and lent long even more eagerly than before—rather than rising, long rates actually subsided. With mortgages now cheaper than ever, house prices continued to head upward.
At the August 2004 FOMC meeting, Greenspan wondered aloud whether markets might be complacent. But he stuck to his promised path of “measured” hikes, and raised interest rates by the expected 25 basis points. By September, longer-term interest rates had subsided again. The lack of market drama was a marvel in some ways—“a central banker’s dream,” as Jeffrey Lacker of the Richmond Fed called it.
In October, with mortgage interest rates still heading down, Greenspan appeared before a convention of community bankers in Washington. With mounting speculation in the media about a property bubble, here was an opportunity to remind home buyers of a home truth: “There is no perpetual motion machine which generates an ever-rising path for prices of homes,” Greenspan had written in his doctoral thesis, in 1977. But instead, Greenspan cast himself as a cheerleader for the housing boom, just as he had once been a cheerleader for the New Economy. Were home buyers borrowing incautiously? Greenspan thought not: the vast majority of families who took out mortgages were fully capable of repaying on schedule. Did home prices reflect a speculative euphoria? Again, Greenspan said no: people generally bought homes not in order to flip them for a quick profit but because they needed to live somewhere. Besides, Greenspan continued, the so-called national housing market was really a collection of distinct cities and regions. “Local economies may experience significant speculative price imbalances,” Greenspan stipulated. But “a national severe price distortion seems most unlikely in the United States, given its size and diversity.”48
Ever since his irrational exuberance speech in December 1996, Greenspan had doubted that jawboning asset prices could achieve much. But if public rhetoric, like regulatory policy, was not going to succeed, perhaps this reinforced the case for leaning against bubbles using interest rates?
• • •
Toward the end of 2004, the Fed’s research brain trust set out to steer the boss in a different direction.49 For the previous couple of years, the staff economists had brushed aside loose commentary about a housing bubble, arguing that the run-up might be justified by the fundamentals of demography, and further that house prices would abate naturally if they were in fact overvalued. But now the economists were worried. Home prices seemed to be deviating from their normal relationships, either to incomes or to rents; rather than borrowing some crazy multiple of wages to buy a home, a sensible family should prefer to rent one more cheaply. The only rationale for buying was that prices, already elevated, would head even higher. But as Greenspan had recognized in the 1970s, price rises supported by nothing more than the expectation of further price rises tend not to be sustainable.
Greenspan listened to the staff economists. Even though they were evidently prodding him to worry more, they seemed to be offering more questions than answers. They were not certain, for example, how to establish basic facts: different measures of home prices showed different rates of appreciation. Comparing uncertain home prices to uncertain rental prices introduced a further level of complexity, especially because houses in the rental market were generally lower quality than owner-occupied houses, creating an apples-to-oranges problem. The one clear conclusion from the economists’ research was that concluding anything was difficult.50 By late 2004, moreover, economists who thought that property was overvalued were on the defensive. Similar predictions had been offered for the previous couple of years. The pessimists had been discredited.
At a different point in his career, Greenspan might have responded to his staff’s presentation more forcefully. If there were ambiguities in the data, surely these could have been resolved with some determined prodding from the chairman—after all, this was what Greenspan had demanded when confronted with anomalies in productivity measures eight years earlier. But this time Greenspan seemed detached, even incurious. His usual appetite for data had apparently deserted him, and at least one staff member guessed that having recently declared publicly that house prices did not constitute a bubble, the chairman was not interested in revising his position. But there was another factor, also. Since his early years as a young data sleuth, Greenspan had loved mechanical relationships: if military procurement went up, aircraft makers’ demand for metal would necessarily go up; if profits rose while prices and wages remained flat, then productivity must be increasing. But house prices, like all asset prices, eluded such clear-cut results. After a lifetime of observing markets, Greenspan was at one with Kohn. He did not believe that markets were always efficient, but he was reluctant to second-guess them.
• • •
By the start of 2005, the Fed’s successive quarter-point hikes had created something of a mystery. The fed funds rate had climbed by a cumulative 125 basis points, but ten-year rates had continued to slide—they were now considerably below where they had been at the start of the tightening. The consequences for real estate were hardly a surprise. On the Gulf Coast of Florida, investors snapped up condominiums that were as yet unbuilt; contrary to Greenspan’s reassuring pronouncements, apartments were being bought, flipped, and sometimes flipped again before anybody so much as lived in them. Property developers dazzled prospective buyers with extravagant parties. At the launch of one ambitious Miami development named Aqua, hostesses in fringed hot pants coaxed home buyers to salsa, and chefs whipped up model crepes in Aqua’s model kitchen. The Mortgage Bankers Association reported that risky adjustable-rate and interest-only loans accounted for nearly two thirds of all mortgage originations in the second half of 2004. An industry insider called the shift to the new products a sure sign of “the end of the housing cycle.”51
At the FOMC meeting on February 1, 2005, Greenspan appeared to show concern at the euphoria. Reacting to another iteration of the long-running discussion about the case for a publicly announced inflation target, he objected that the Fed’s job might have to be defined more broadly. “Are we dealing solely with the prices of goods and services, or do asset prices enter into the evaluation?” he demanded. “Is macroeconomic stability, and specifically financial stability, a factor that must be taken into account?” Rather than using the Fed’s interest-rate lever solely to target inflation, Greenspan was saying, there might be a case for using it to restrain leverage and bubbles. Again, the postcrisis insistence that monetary policy was irrelevant to asset prices was not always evident before the crisis.
“I have a suspicion that future FOMCs will eventually come to decide . . . that asset prices are a relevant consideration,” Greenspan continued.52 The Fed should “try to mold a level of financial stability that cannot be achieved without advertence to asset prices.” Hinting at the gathering mortgage storm, Greenspan went on, “Unless human nature has changed beyond my expectations, I believe it’s extraordinarily unlikely that we will be as fortunate as we’ve been in recent years.” Perhaps the Fed staff’s warning about house prices had unsettled him after all.
Now that Greenspan was the one sounding a warning about bubbles, it was the turn of others in the room to seem detached, even incurious. After all, the chairman was not offering a clear bottom line: like the Fed’s housing experts, he was raising questions rather than providing answers. It was all very well to pronounce vaguely about how asset prices might matter. He was not saying how the Fed should respond to them.
One after another, the FOMC members spoke up, pointedly ignoring Greenspan’s musings.
Presently, one said, “Mr. Chairman, you raised the question of asset prices, and I notice that nobody has commented on that, so let me.
“Asset prices are a fundamentally different breed of cat,” the governor insisted flatly.53
Greenspan said nothing. He could not really object; even if some part of him liked to relive the bubble preoccupations of his younger days, he basically agreed that asset prices should be left to find their own level. After a few more apocalyptic hints during the next day’s discussion, the chairman retreated to safe ground. The chief risk confronting central bankers, he now said, was an acceleration of inflation.
It was a strange mixture, this combination of prescient foreboding and conventional wisdom, of musings that recalled a youthful preoccupation with finance and conclusions that fitted perfectly within the inflation-targeting straitjacket. Nearing his seventy-ninth birthday, Greenspan had lived many lives. Sometimes he seemed to want to be both icon and iconoclast.
• • •
Two weeks later, on February 16, 2005, Greenspan attached a name to the unusual behavior of long-term interest rates. “The broadly unanticipated behavior of world bond markets remains a conundrum,” he testified to Congress. Normally, he lectured, a 150 basis point rise in the fed funds rate would drive long rates up; after all, the ten-year interest rate could be thought of as the average of the short rates over the period. So if long rates remained weirdly low, why might this be? Inflation expectations had certainly not fallen dramatically enough to provide an explanation. Nor were investors expecting a weak economy. Greenspan even doubted the leading theory among his colleagues.54 During an FOMC meeting two months earlier, Ben Bernanke had pointed to a “savings glut.” Long-term loans were cheap because capital was in plentiful supply, Bernanke had observed. Savings were flooding into the United States from China and other countries.
The savings-glut theory was more plausible than Greenspan acknowledged, and later he would come around to it. China, like other emerging economies, was buying up long-term bonds issued by the U.S. government and other Western powers, helping to explain why long-term rates were low—including rates on long-term mortgages. In keeping with this theory, the housing bubble of the mid-2000s was not confined to the United States, encouraging Bernanke and his allies to argue that global savings patterns were the culprit. Yet although there was some truth to this analysis, it was not the whole story. Later research confirmed that Chinese savings patterns did indeed influence U.S. long-term interest rates, but also that this effect could be swamped by changes in Fed policy.55 Moreover, to the extent that the U.S. housing bubble had analogs in Europe, a glut of foreign savings was not mainly to blame. In some smaller European economies, notably Spain, the housing bubble was the result of the new common currency, the euro, which had brought about a collapse in borrowing costs. Elsewhere the bubble reflected the policies of central banks that shared the Fed’s inflation-targeting mind-set: Britain was a good example. But the chief omission in the savings-glut theory was the Western financial system itself. In the United States especially, but also in Europe, the cause of the housing bubble was not simply a general surfeit of savings. It was that banks and various species of investment fund were scooping up those savings and pumping them into real estate. If financiers had chosen differently, there would not have been a bubble.
In the years after the crisis, Greenspan suggested that there was nothing the Fed could have done to change financiers’ choices. If long rates remained low despite rising short rates, it followed that the Fed was powerless. This claim of central-bank impotence was part of a tradition: in 1975 Arthur Burns had lamented that the Fed could not be expected to bring inflation down because “all of us recognize that the influence the Federal Reserve has on long-term rates is negligible.”56 But as Greenspan should have recalled from his own observations of the 1970s, this claim of impotence was false. In the 1970s, long rates had stopped rising in tandem with short rates because Fannie and Freddie were creating a new source of long-term loans; the answer, as Volcker ultimately showed, was to hike short rates more aggressively. In the 2000s, similarly, long rates had stopped rising with short rates. The answer, again, was to hike short rates more—and to stop coddling investors with advance warning of the Fed’s decisions.57
Greenspan might also have reflected on another episode from his career: the 1993 bond market bubble. Then, in keeping with the tradition of claiming monetary impotence, Greenspan had ascribed the collapse of long-term interest rates to factors other than the Fed: inflation expectations were falling. The following year, when the Fed hiked the short-term interest rate, the bond bubble popped: the Fed turned out to be the opposite of impotent. Moreover, Mike Prell and the research department had explained why Greenspan had been wrong: low long-term rates in 1993 were the product of an extended spell with a rock-bottom federal funds rate. Prell’s point was that monetary policy determined investors’ expectations about interest rates in the future, and that those expectations fed through into long-term interest rates: “The persistence of low short rates will gradually lower investors’ perceptions of what is normal and sustainable,” Prell had concluded. If that had been true in the era before the Fed guided expectations deliberately, it was presumably all the more true now that the Fed was promising to raise rates only gradually.
A month after the conundrum speech, at the FOMC’s meeting in late March 2005, Timothy Geithner put his finger on the trouble with the Fed’s forward guidance, noting “a remarkable reduction in uncertainty about monetary policy expectations.” Because there were no surprises left in monetary policy, investors sated their risk appetites by leveraging their portfolios and buying higher-yielding bonds. The result was “this broad pattern now evident of lower risk premia across financial markets.”
“Part of this is due to fundamentals,” Geithner stipulated, alluding to the possibility that a flood of savings from China might indeed be suppressing long-term interest rates. “But part seems due to our monetary policy signal,” he added pointedly. So long as Wall Street remained confident that Fed tightening would be “measured,” it had absolutely no reason to stop borrowing short and lending long.58 The Fed’s soothing pronouncements were stoking a dangerous appetite for risk—an appetite that was not going to be suppressed by the New York Fed’s regulatory efforts.
If Geithner worried about the incentives created by forward guidance, other thoughtful figures on Wall Street were even more nervous. Through 2004 and 2005, Tom Maheras, the head of trading operations at Citigroup, conducted a running conversation with his top Fed-watching economists, Lewis Alexander and Kim Schoenholtz. The way Maheras saw things, the Fed was too predictable and too soft. In 1998, it had cushioned the shock of LTCM’s failure by overreacting with rate cuts, encouraging Wall Street to believe that it was safe to take on leverage: if markets blew up, the Fed would put things right and protect traders from losses. Now the Fed was compounding its post-LTCM error by telegraphing its moves in advance, Maheras thought. Greenspan ought to hit speculators with a surprise rate hike of 50 or 75 basis points, as he had in 1994. Otherwise, Wall Street would leverage itself indefinitely.59
Alexander and Schoenholtz listened to their boss, but they rejected his prescription. By now every serious Fed watcher had absorbed Ben Bernanke’s case for clear central bank communication. The Fed had signaled it would tighten at a “measured” pace, and Greenspan had to stick to the plan; in a modern, financialized economy, a central bank did not so much set interest rates as seek to guide them, so its credibility was everything. Besides, inflation was just about on target, at a touch over 2 percent. There was no case to be made for hiking the fed funds rate more aggressively.
A curious pattern was emerging. Monetary experts wanted to preserve their interest-rate tool to stabilize inflation and, secondarily, employment. They therefore hoped that financial stability would take care of itself, that some combination of market self-discipline and regulatory discipline would contain excesses—and that if they did not, the Fed could clean up afterward. But the creators of those excesses lacked faith in this approach: they wanted to be smacked around by a sterner monetary authority. In the view of Tom Maheras and other senior Wall Streeters, the faith in market self-discipline was a dangerous delusion: bank shareholders did not care about long-term risk; they wanted immediate profits. Likewise, the faith in regulatory discipline was a delusion, too: regulators struggled to define clear rules; balkanized agencies could not coordinate their efforts. And the shattering of these delusions could be scary to behold, potentially swamping the Fed’s ability to clean up afterward. Perhaps not surprisingly, traders in the markets sensed these risks more viscerally than monetary experts.
Although he had laid out the problem with forward guidance, Timothy Geithner stopped short of demanding a tougher monetary policy. He had been at the Fed for just over a year, and like everybody there, he deferred to Greenspan’s record of success over almost two decades. Besides, as Geithner himself conceded, there were risks in being tough: even if the Fed’s forward guidance lulled traders into taking too much risk, it seemed perverse to address the problem of a potential future shock by shocking markets preemptively.60 As a result, nobody around Greenspan really challenged his thinking; and at successive FOMC meetings through the rest of the year, Greenspan persisted serenely with his “measured” strategy. Far from viewing the conundrum of low long rates as a problem to be fixed, he marveled at the smoothness with which monetary policy was operating. “The market now pretty much anticipates how we’re going to respond to various events,” he rejoiced in May 2005. “The markets will do our work for us until we come and sit at this table and formalize it.” In these circumstances, the Fed’s goal was to “continue to convey to the marketplace where our priorities are.” Forward guidance would ensure “as little reaction to our post-meeting statement as possible.”61
In the space of eighteen months, Greenspan had fretted that Wall Street was “reaching for yield,” anticipating that “untoward things” might happen. He had objected to an explicit inflation target, musing that a future FOMC might come to regard asset prices as “a relevant consideration.” He had listened to colleagues’ concerns about the risks in forward guidance, and had come close to embracing their anxiety by diagnosing a “conundrum.” And yet despite the chairman’s depth of understanding, Fed policy remained unchanged. Greenspan was the man who knew. He was not the man who acted.
• • •
Comfortable in his pattern of measured quarter-point rate hikes, Greenspan was savoring his last months as Fed chairman. He had recently visited Scotland to deliver a lecture in Adam Smith’s birthplace, Kirkcaldy; his friend, the brainy British finance minister, Gordon Brown, had shown him around the seaside town and presented him with an early edition of Smith’s The Wealth of Nations. In Washington, Greenspan kept up a full social schedule, courting the press and lunching with cabinet officials; he still played tennis and golf regularly at the Chevy Chase Club. In May 2005, the press speculated briefly that Greenspan’s Fed tenure might be extended beyond its scheduled expiration, on January 31, 2006; if he could hang on into May, he would become the longest-serving Fed chairman, overtaking William McChesney Martin.62 But the speculation did not last. Although Greenspan’s latest appointment as chairman would not expire until 2008, his term as a Fed governor was due to end; the rules allowed a governor to complete his predecessor’s appointment, and then to be appointed to a single fourteen-year term—beyond that, extensions were impossible. One of the most extraordinary careers in Washington was thus drawing to a close. Soon, the Greenspan era would be over.
On Saturday, August 20, 2005, Greenspan flew to Jackson Hole, leaving a few days earlier than usual. Rather than playing tennis in Carmel afterward, he had opted for a break ahead of the symposium. This year’s proceedings were to be titled “The Greenspan Era: Lessons for the Future.” He wanted to be ready.
Greenspan had every reason to expect a rapturous send-off. In the eighteen years since Reagan had appointed him, the U.S. economy had experienced only two recessions: in 1990–91 and in 2001. Taking these two episodes together, the United States had been in recession for just 7 percent of Greenspan’s tenure, whereas Burns had presided over a recession for 26 percent of his time, and Volcker had done so for 23 percent. Greenspan’s record on price stability had been better still. Since the soft landing in the spring of 1994, core inflation had never risen above 2.3 percent; it had been lower and less volatile than at any time since the 1960s. Economists had dubbed this miracle the Great Moderation. A few journalists and dissidents might fret about forward guidance and bubbles. But when it came to the central bank’s main mission of stabilizing growth and inflation, Milton Friedman’s verdict was correct. Greenspan had “set the standard.”
On Friday, August 26, the monetary priesthood gathered expectantly in the Jackson Lake Lodge, with its picture windows looking out over the mountains. After introductory remarks from Greenspan, in which he modestly invoked the “inevitable and ongoing uncertainty” that central bankers faced, the stage was taken by none other than Alan Blinder. As Fed vice chairman in the mid-1990s, Blinder had frequently quarreled with Greenspan, accusing him of substituting his own mysterious intuition for model-driven forecasts. But now, assessing the cumulative evidence from Greenspan’s long chairmanship, Blinder had revised his view. Together with Ricardo Reis, a Princeton colleague, he showered Greenspan with extraordinary praise, piling superlative upon superlative.
Greenspan had a “legitimate claim to being the greatest central banker who ever lived,” the paper delivered Blinder and Reis contended.
“There is no doubt that Greenspan has been an amazingly successful chairman of the Federal Reserve System,” they added.
“Financial markets now view Chairman Greenspan’s infallibility more or less as the Chinese once viewed Chairman Mao’s.”
He had demonstrated “subtlety, a deft touch, and good judgment.”
He had handled the Fed “with great aplomb, and with immense benefits to the U.S. economy.”
If there was any criticism of Greenspan, it was that he had been too commanding and brilliant. “Alan Greenspan has become what amounts to the nation’s unofficial economic wise man—on just about any subject,” the professors chided. He had boosted his stature to the point that he overshadowed his own institution.
But then Blinder and Reis conceded, “If the nation wants a wise man, it could do a lot worse than Alan Greenspan.”
The praise started again.
“The coming replacement of Alan Greenspan by a mere mortal in January 2006 will not . . . be like changing dentists.”
Greenspan was “a living legend.”
He was the “maximum maximorum.”
“His job performance has, in the current vernacular, been awesome.”
At the end of the symposium, Greenspan rose to address the priesthood one last time. “Difficult challenges lie ahead,” he said, “some undoubtedly of our own making.”63